Trust accounting is a set of procedures that law firms must follow when handling clients’ money. The stakes are high: trust account mismanagement is “one of the most frequent causes of [attorney] disciplinary action.” By getting it right, your law firm can maintain clients’ trust, protect the firm’s reputation, avoid professional discipline, and control liability exposure. This law firm trust accounting guide will show you how.
What Is Trust Accounting for Law Firms?
Trust accounting for law firms means the processes that law firms are required to use when handling their clients’ money.
Attorneys (and all law firm staff) have a special duty to safeguard their clients’ money, because attorneys are fiduciaries for their clients. As fiduciaries, attorneys must act in their clients’ best financial interest. That includes:
- Keeping the firm’s money separate from the clients’ money.
- Promptly notifying the client when the firm receives money that belongs to the client, and prompt disbursing that money to the client.
- Recording the details of all transactions that involve client money.
- Reconciling accounts frequently to detect and correct errors that impact client money.
To keep clients’ money separate from the firm’s money, the firm must have two separate account types: operating accounts and client trust accounts.
- Operating account(s): These hold the firm’s money, like fees that have been earned and properly transferred from the operating account.
- Client trust account(s): These hold clients’ money, like retainers and advanced fees, escrow deposits, settlement funds, and other funds received on the client’s behalf.
Why Trust Accounting Matters (Compliance & Risk)
If a law firm mismanages client trust accounts, the consequences can be serious.
Risk of Ethical Breaches
ABA model rule 1.15 lays out the typical ethical duties for trust accounting. (Law firms must follow their state’s ethical rules, and there can be significant variations between states.) If a law firm does not comply with ethical rules, attorneys can face disciplinary action: public reprimand, fines, suspension, and disbarment.
Other Risks
The risks of trust accounting mistakes go beyond the ethical issues.
- The firm might owe damages if a client whose money was mismanaged files a civil suit.
- If the mismanagement rises to the level of fraud, the individuals involved could face criminal consequences.
- The firm might experience reputational damage if people lose trust in the firm’s ability to handle client funds properly. That could have long-term impacts on the firm’s financial sustainability.
Common Trust Accounting Errors to Avoid
The rules for trust accounting are not always intuitive, and it is easy to make mistakes. The most common problems include:
- Commingling client and firm funds. Firms can prevent commingling by creating separate accounts, implementing strong accounting controls, and using software designed for trust account compliance. General purpose accounting software can make mistakes that expose the firm to risk, like applying a chargeback to the trust account.
- Reconciliation errors. Firms can avoid reconciliation problems by conducting regular three-way reconciliations and creating robust cross-checking procedures to spot errors. Typically, three-way reconciliations should be performed monthly so that any errors are caught and fixed early.
- Record gaps. Trust accounting requires extensive documentation so that every client dollar can be tracked. Firms can head off errors by keeping up to date with record-keeping requirements, creating clear written procedures, implementing supervision, and cross-checking to make sure the procedures are followed.
Best Practices for Trust Accounting Compliance
There are five core trust accounting compliance best practices: separate client funds, keep detailed records, create written procedures with strong controls, conduct monthly three-way reconciliations, and communicate clearly with clients.
1. Separate Client Funds
This principle is simple, but it can be difficult to apply. Commingling examples include (but are not limited to):
- Using client funds to pay law firm expenses. Never pay firm expenses from the trust account, even if the money has been earned. Move it to the operating account first.
- Moving client money to the operating account before it has been earned. In most cases, retainer funds must be stored in the trust account until they are earned.
- Failing to move earned fees to the operating account regularly. This may seem counter-intuitive, but it is an example of storing the firm’s money in the trust account.
- Handling fixed fees improperly. There is significant variation among states on this issue. Some consider fixed fees to be earned upon receipt; others require lawyers to keep fixed fees in trust until earned.
Note: Most states make an exception to the commingling prohibition for banking fees. In general, law firms may deposit their own funds in the trust account to pay for normal banking fees. Keeping a significant amount of firm funds in the trust account, however, may be a violation.
2. Keep Detailed Records
Trust accounting requires especially meticulous recordkeeping. The ABA Model Rules on Client Trust Account Records, Rule 1, provides a good overview of what is typically required:
- A journal of deposits and withdrawals from trust accounts
- A ledger for each client trust account
- Copies of retainer and compensation agreements
- Copies of any accountings to clients or third parties
- Copies of bills for legal fees and expenses
- Copies of records showing disbursements on behalf of clients
- Financial institution records like checkbook registers, bank statements, deposit records, cancelled checks, and substitute checks
- Detailed records of electronic transfers
- Copies of trial balances and reconciliations
- Copies of the parts of the client file that relate to trust accounting.
Of course, check your state’s guidelines to see what your jurisdiction requires.
3. Create Written Procedures with Strong Controls
Even if your accounting team is small, written procedures are essential for staying on track. Procedures should cover trust accounting workflows, supervision, controls, and encourage prompt reporting of problems so any errors can be corrected swiftly. Procedures should be reviewed and updated regularly.
4. Conduct Monthly Three-way Reconciliations
Trust accounting requires three-way reconciliation. All funds, down to the penny, must be accounted for. You must compare:
- The bank statement against your trust ledger.
- The bank statement against each client’s trust ledger.
Three-way reconciliations should be done on a regular schedule and frequently enough to catch errors promptly. Trust errors tend to snowball, so finding them early benefits everyone.
Many firms find it works best to reconcile monthly right before billing statement creation.
5. Communicate Clearly with Clients
Keeping the client informed about their funds is part of the attorney’s fiduciary duty and trust accounting compliance best practices. Examples trust account communication include:
- The engagement letter or fee agreement, which should clearly state how money will move through the trust account.
- Statements, which should be sent regularly and should include a summary of the client’s trust account ledger. It is a best practice to send a statement whenever you pay earned fees from the trust account, even if no additional money is owed.
- Notifying the client when the attorney receives funds on their behalf. The funds must also be disbursed to the client within a reasonable period of time to avoid commingling.
Understanding Trust Account Types & IOLTA Accounts
Sometimes people refer to trust accounts as IOLTA (Interest on Lawyer Trust Account) accounts, but not every trust account is an IOLTA account. The type of trust account depends on the interest-earning potential of the client money held.
- If the client would earn a minimal amount of interest (because the amount of money is small or it will not be held for long), it is pooled with other client funds in an IOLTA account. The interest that accrues on IOLTA accounts is used to fund access to justice.
- Larger amounts, or amounts held for a long time, are held in regular interest-bearing accounts (not IOLTA). The interest belongs to the client.
How to Streamline Trust Accounting With Tabs3 Financials
Tabs3 Financials in Tabs3 Cloud offers powerful support for trust accounting for law firms to lighten your load.
- Instant communication with your bank, easy-to-read trust ledgers, and streamlined three-way reconciliation reports so you can reconcile faster.
- Flexible recordkeeping so you can store all the details needed for compliance.
- Dashboard summaries to help you spot trust problems early.
- Seamless integration with Tabs3 Billing and Tabs3Pay, an electronic payment solution built for lawyer trust account compliance.
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